401(k)s For Dummies

Part I

Getting Started

In this part . . .

S aving in a 401(k) is potentially one of the best deals that you’ll ever get. 401(k) plans offer significant tax breaks and other advantages, and very few drawbacks. But you have to know what you’re doing in order to get the full benefit from your plan. This part explains how 401(k) plans work, how to evaluate the plan your employer offers, and what to do when you sign up for your plan.

Chapter 1

Benefiting from Your 401(k)

In This Chapter

bullet Understanding how a 401(k) plan works

bullet Getting the most tax savings, extra money, and other advantages

bullet Improving your chances for an ideal retirement

N ot too long ago, many people would ask, What the heck is a 401(k)? Today, however, 401(k) is a household word. People discuss their 401(k) investments at social gatherings. These once-obscure plans are in the national media nearly every day.

401(k) plans have helped more than 40 million workers save for retirement. Because Social Security alone won’t provide adequate retirement income, and fewer companies offer a traditional pension plan, 401(k)s have become an essential part of the average worker’s future plans.

Even young people, for whom retirement would normally be low on the priority list, have jumped on the retirement savings bandwagon. They’re the smart ones, because in some respects, how long you save is more important than how much you save.

Unfortunately, the stock market nosedive and corporate scandals in the early 2000s caused 401(k) plans to come under some fire. Many workers who made bad investment choices saw large drops in the value of their accounts. Some blamed the 401(k) itself, but that’s like blaming the messenger who brings you bad news. If you take the time to understand and follow basic investing principles (see Chapters 5 and 6), your 401(k) can grow into a nest egg that can help you retire comfortably.

The beauty of a 401(k) is that it makes saving easy and automatic, and you probably won’t even miss the money that you save.

Defining What a 401(k) Does for You

A 401(k) plan lets you put some of your income away now to use later, presumably when you’re retired and not earning a paycheck. This procedure may not appeal to everyone; human nature being what it is, many people would rather spend their money now and worry about later when later comes. That’s why the federal government approved tax breaks for 401(k) participants to enjoy now. Uncle Sam knows that your individual savings are going to be an essential part of your retirement, and wants to give you an incentive to participate.

When you sign up for a 401(k) plan, you agree to let your employer deposit some of your paycheck into the plan as a pre-tax contribution, instead of paying it to you. Your employer may even throw in some extra money known as a matching contribution (see Chapter 2). You don’t pay federal income tax on any of this money until you withdraw it.

Of course, there’s a catch. Some 401(k) plans may not allow you to withdraw money while you’re still working. Even if yours does allow you to withdraw money while working, if you’re under 59 1/2 years old, withdrawals can be difficult and costly. Check out Part III for a full explanation of these rules and regulations.

How much your 401(k) will be worth when you retire depends on a number of factors, such as what investments you choose, what return you get on those investments, whether your employer makes a contribution, and whether you withdraw money early. The next few sections take a look at the benefits of participating in a 401(k).

Lowers how much tax you pay

A 401(k) lets you pay less income tax in the following two ways:

bullet Lower taxable income: You don’t have to pay federal income tax on the money you contribute pre-tax to your 401(k) plan until you withdraw it from the plan.

bullet Tax deferral: You don’t pay tax on your 401(k) investment earnings each year — only when you make withdrawals.

The government provides these big tax breaks in an attempt to avoid having a country full of senior citizens who can’t make ends meet. (Nice to know the government’s on top of things, huh?)

Lower taxable income

The money that you contribute to a 401(k) reduces your gross income, or taxable income (your pay before tax and any other deductions). When you have lower taxable income, you pay fewer of the following income or wage taxes:

bullet Federal taxes: These taxes increase as your income increases — for 2002, the rate for most workers is either 15 or 27 percent, and the top tax rate is 38.6 percent.

bullet State taxes: Many states impose their own income or wage taxes, ranging from less than 1 percent to as much as 12 percent in 2002, depending on the state.

bullet Local/municipal government taxes: Many local and municipal governments also have income or wage taxes.

In most states, you aren’t required to pay state or local taxes on contributions to your 401(k). However, a few states may require you to list all or part of the money that you contribute to a 401(k) as taxable income on your state tax return. You still get the federal tax break, however. Check with your state and local tax authorities if you’re not sure what the rules are where you live.

Taxes that you don’t avoid, because everybody has to pay them on gross income (including 401(k) contributions), are Social Security/Medicare (FICA) and unemployment (FUTA).

Here’s an example of how you save money when you contribute some of your pay pre-tax to a 401(k). Assume that:

bullet Your gross pay is $2,000 each pay period.

bullet You’re in the 27 percent federal tax bracket.

bullet Your state income tax is 2 percent, local income tax is 1 percent, and your FICA/FUTA taxes are 7.65 percent.

bullet Contributions you make to a 401(k) plan are exempt from state and local tax.

Say you don’t contribute to a retirement plan. Look what happens to your income after you pay all those taxes:

Gross pay $2,000

Federal income tax –$350

State income tax –$40

Local wage tax –$20

FICA/FUTA taxes –$153

Take-home pay $1,437

Now assume that you contribute 6 percent, or $120, per paycheck to a 401(k) plan. Your FICA/FUTA taxes will be the same, but the other taxes are lower because they’re based on a lower income (your gross income minus your retirement contribution). Here’s how it breaks down:

Gross pay $2,000

Retirement contribution –$120

Federal income tax –$329

State income tax –$38

Local wage tax –$19

FICA/FUTA taxes –$153

Take-home pay $1,341

You invested $120 for your retirement, but your take-home pay is reduced by only $96. For the time being, you’re up $24 that would otherwise have gone to the government. You don’t have to pay these taxes until you withdraw your money from the plan. As a general rule in this tax bracket, if you contribute $1, your take-home pay is reduced only by about 70 to 80¢.

Here’s another way of looking at it. Without a 401(k) plan, taxes eat away the money that you could save. Assume that your employer doesn’t offer a 401(k) or other retirement plan, and your total tax rate is 37.65 percent (7.65 percent FICA/FUTA, 27 percent federal income tax, 2 percent state income tax, and 1 percent local wage taxes). After paying these taxes, it takes almost 16 percent of your gross income to have 10 percent left to invest for retirement. The following example shows how this works.

Assume that you earn $50,000 a year, and your goal is to save 10 percent, or $5,000. You would have to earn $8,017 in order to have $5,000 left after-tax.

Pre-tax earnings required $8,017

Federal income tax –$2,164

State/local wage tax –$240

FICA/FUTA taxes –$613

Amount left to save $5,000

Now assume that your employer offers a 401(k) plan, and you can save the $5,000 in your 401(k) account. In this case, the only tax you have to pay at the time you make the contribution is FICA/FUTA. As a result, you need to earn only $5,414 in order to be able to contribute $5,000 to the 401(k) plan.

Pre-tax earnings required $5,414

Federal income tax –$0

State/local wage tax –$0

FICA/FUTA taxes –414

Amount left to save $5,000

Without a 401(k) plan, it takes you $8,017 in pre-tax income to save $5,000 after taxes. When you can save pre-tax money in your 401(k), it only takes $5,414 to save the same $5,000. In other words, with a 401(k), it will cost you less of your current earnings to save the same amount. Pretty good deal, don’t you think?

Some plans allow you to make after-tax contributions. You don’t get the initial tax break of lower taxable income, but you do benefit from deferring taxes on your investment earnings.

Tax deferral

In addition to the income tax savings on your contributions, you also save when it comes to paying tax on your investment earnings.

The gains in your 401(k) aren’t taxed annually, as they would be in a regular taxable bank savings account, a personal mutual fund account, or a brokerage account (which you may use to buy and sell stocks and other investments). With a 401(k), you defer paying taxes on your investment earnings until you withdraw the money.

Figure 1-1 shows how tax-deferred compounding lets your money grow faster than it would in a taxable account. It compares the results of investing $5,000 at a 9 percent return in a tax-deferred account with investing $3,750 in a taxable account ($3,750 = $5,000 less income tax) at a 9 percent return, taxed each year at a 25 percent tax rate.

Gets you something extra from your employer

Whoever said there’s no such thing as a free lunch didn’t know about employer matching contributions — money that your employer will contribute to your 401(k) if you contribute to the plan. (Not all employers make this type of contribution, but many do.)

The most common formula is for the employer to put in 50¢ for every dollar you contribute up to 6 percent of your salary. Because 50¢ is half of one dollar, the most your employer will contribute is half of 6 percent, or 3 percent of your salary. You get this full 3 percent only if you contribute 6 percent of your salary. Chapter 2 gives examples of how this matching contribution works.

The employer matching contribution can be the single most important feature of your 401(k) plan. The more you get from your employer, the less you have to save out of your own paycheck to achieve an adequate level of retirement income. In fact, if your employer offers a matching contribution, make sure that you con-tribute enough to your plan to get it all. If you don’t, this money will be lost to you.

You may have to stay with your company for a minimum length of time before the employer contributions vest, or belong to you, a topic we discuss in more detail in Chapter 2. But if you can meet that requirement, the money’s yours, as well as any return it’s earned in the meantime.

How 401(k) became a household word

The 401(k) is named after the section of the IRS rulebook (the Internal Revenue Code, or IRC) that governs how it works.

Section 401 applies to many different tax-qualified retirement plans — those with special tax advantages for you and your employer. It begins with paragraph (a) and includes paragraph (k), which was added when Congress enacted the Tax Reform Act of 1978.

Paragraph (k) was one of those special interest paragraphs added to the bill in the 11th hour. Its original objective was to cover a specific type of Section 401 plan that was sponsored by banks for their own employees.

It was only a couple of years later, when Ted was designing a retirement plan for a company, that he realized that paragraph (k) offered additional possibilities. The result was the first 401(k) savings plan with employer matching contributions and employee pre-tax contributions made through payroll deductions. It wasn’t universally accepted at first, but after the Treasury Department okayed it in 1981, it began to catch on.

And the rest, as they say, is history.

Saving Without Tears

A big benefit of signing up for your 401(k) plan is that you don’t have to think about the fact that you’re saving. Out of sight, out of mind is what happens to most people — they don’t even miss the money, because it’s taken out of their paycheck before they have a chance to spend it.

This semi-forced savings is one of the most valuable benefits of 401(k) plans. The payroll deduction has the power to convert spenders into savers. Most people are unable to save over a long period of time if they have to physically write the check or make the deposit each pay period. Saving becomes the last, not the first, priority. Many participants have said that the 401(k) has helped them save thousands of dollars that they otherwise would have spent carelessly.

It’s a good idea to increase your 401(k) contributions if you get a raise or a bonus. In fact, do it right away so that you don’t get used to spending the extra money.

Taking Your Savings with You When You Change Jobs

When you change jobs, you can take your 401(k) money with you — and keep the tax advantages — by putting it into your new employer’s 401(k), 403(b), or 457 plan, or into an IRA (Individual Retirement Account).

Transferring your money to a new employer’s plan or an IRA is known as a rollover or trustee-to-trustee transfer. See Chapter 8 for more on rolling your money into an IRA; see Chapter 10 for details about 403(b)s, and Chapter 11 for information about 457 plans.

Many employers require you to work for a minimum number of years before the employer contributions are yours to keep (known as vesting). See Chapter 2 for more details on vesting procedures.

Because your 401(k) is portable, you can build up a retirement nest egg even if you change jobs fairly frequently. This beats the traditional defined- benefit pension plan (in which you receive a set amount from your employer each month in retirement, if you qualify). With those plans, you can lose all retirement benefits if you don’t work at the company for the minimum vesting period — this can be at least five years, or even longer at some companies.

Letting the Pros Work for You

Have you ever wished that you could hire a professional money manager to handle your investments? A 401(k) lets you take a step in that direction by offering mutual funds.

Mutual funds are investments that let you pool your money with the money of hundreds or thousands of other investors. An investment expert called the fund manager decides how to invest all this money, trying to get the best return on your investment based on the fund’s investment objective. Because the fund manager invests your money along with the money contributed by other investors in the fund, she has more money to invest and can spread it around to different companies or sectors of the economy. This diversification helps reduce the amount of risk that you take with your investments. (We explain more about selecting investments, including mutual funds, in Chapter 6.)

What does this mean for you? If you choose your fund carefully, you benefit from a professional money manager who’s seeking the best return for the fund’s investors, based on the fund’s investment objectives.

In most cases, your employer is responsible for choosing the mutual funds (and any other investments) offered by your 401(k) plan. More than 8,000 mutual funds are registered in the United States. If your employer does a good job of narrowing the offering down to a handful, it can save you a lot of time.

Rather than rely on choices made by their employer, however, some investors prefer to choose their own investments, such as individual stocks, mutual funds, or other investments that aren’t included in their plans. Some 401(k) plans now offer a brokerage window that allows you to choose your own investments. But you generally pay an extra fee if you use this feature. Chapter 6 has more details on brokerage windows.

Buying More When Prices Are Low

When you invest a specified amount at regular intervals, as you do with automatic 401(k) contributions from your paycheck, you are using an investment strategy called dollar cost averaging. (You didn’t know you were that smart, did you?) This investment strategy may lower the average price that you pay for your investments. How? Because you’re spending the same amount each time you invest, you end up buying more shares of your investments when prices are low and fewer shares when prices are high. By averaging high and low prices, you reduce the risk that you will buy more shares when prices are high.

Of course, if stock prices only go up for the entire time you invest, this strategy won’t work. But if you contribute to a 401(k) over a long period of time, there will likely be periods when prices go down.

Improving Your Chances of an Ideal Retirement

Investing in a 401(k) gives you a chance at extra savings for your retirement years. The additional savings can mean the difference between merely surviving retirement and actually living it up.

Did you ever stop to think how much money you’ll need in retirement to keep up your current lifestyle? Most financial planners suggest that you’ll need at least 70 to 80 percent of your pre-retirement income. But many people may need closer to 100 percent, or more.

Some people think that their Social Security benefits alone will be enough to cover their retirement needs. The unfortunate fact is, you shouldn’t rely on Social Security to finance your retirement. Financial security during retirement requires income from a variety of sources. Social Security’s current problems are serious, but the system was never intended to be the sole source of retirement income for Americans.

Try to estimate how big a retirement account you’ll need, and develop a savings plan to try to accumulate that amount. When you retire, you’ll have to manage your nest egg so that you don’t run out of money before you die. Chapter 4 explains why and how to set up a savings plan for your 401(k) during your working years, and Chapter 9 looks at ways to make this money last after you retire.

Protecting Your Money

Investing money always involves some risks, but money in a 401(k) plan is protected in some ways that money in an ordinary savings account, brokerage account, or IRA isn’t.

Meeting minimum standards

401(k) plans are governed by a federal law called ERISA — the Employee Retirement Income Security Act. Passed in 1974, ERISA sets minimum standards for retirement plans offered by private-sector companies. (Some nonprofits also follow ERISA rules, but local, state, and federal government retirement plans, as well as church plans, don’t have to.)

ERISA requirements include:

bullet Providing information to you about plan features on a regular basis, including a summary plan description outlining the plan’s main rules, when you enroll in the plan and periodically thereafter

bullet Defining how long you may be required to work before being able to sign up for the plan or before employer contributions to the plan are yours to keep if you leave your job

bullet Detailing requirements for the plan fiduciary, essentially including anyone at your company or the plan provider who has control over the investment choices in the plan (A fiduciary who breaks the rules may be sued by participants.)

This last point, fiduciary responsibility, is important to understand. Essentially, it means that anyone who has a decision-making role in your 401(k) plan’s investments is legally bound to make those decisions in the best interests of the plan participants (you and your co-workers), and not in the best interest of the company, the plan provider, or the fiduciary’s cousin Joe. For example, the committee in charge of choosing a 401(k) provider shouldn’t choose Bank XYZ just because the company president’s cousin runs the bank.

But this doesn’t necessarily mean that you can sue your employer if your 401(k) doesn’t do well. (Keep in mind that lawsuits are often costly and won’t endear you to your employer.) If you lose most of your money because you make bad investment decisions or the stock market takes a nosedive, but your employer has followed ERISA rules, your employer is off the hook. Your employer may gain limited protection through something called 404(c). Without going into too much detail, Section 404(c) of ERISA requires your employer to provide you with specific information about your plan, including information about the investment options, and to allow you to make changes in your investments frequently enough to respond to ups and downs in the market. In return, you assume liability for your investment results.

Plan operation was a critical point in the case of Enron, the Houston-based energy trading company that declared bankruptcy in late 2001. Many employees suffered huge losses in their 401(k)s because they had invested heavily in Enron stock based on the rosy picture that was painted by senior management about the company’s fortunes. When that rosy picture turned out to be a fake, employees hollered that they wouldn’t have invested so much in Enron stock (one of their 401(k) investment options) if they had known the truth.

Avoiding losses in bankruptcy

Many people wonder whether their 401(k) money is at risk if their employer goes belly-up. The answer is usually no, with a few caveats:

bullet If the money is in investments that are tied to your employer, such as company stock, and the employer goes bankrupt, you may lose your money. (This is a compelling argument for you to limit the amount of your 401(k) that you invest in a single stock.)

bullet In the case of fraud or wrongdoing by your employer or the trustee of the 401(k) account, your money may be at risk. (The trustee would be personally liable to return your money, but that’s no help if he has disappeared.) These situations are rare; what’s more, your employer is required to buy a type of insurance — a fidelity bond — when it sets up the plan, that may enable you to recoup at least some of your money in the event of dishonesty. (Fidelity bonds generally cover 10 percent of the amount in the entire plan, or $500,000, whichever amount is smaller.)

bullet Part of your money may be lost if your employer goes out of business or declares bankruptcy before depositing your contributions into the trust fund that receives the 401(k) money that is deducted from your paycheck.

Federal law says that if you declare personal bankruptcy, your creditors generally can’t touch your 401(k). They may be able to get at your other savings, but your 401(k) should be protected. Exceptions include if you owe money to the IRS or if a court has ordered you to give the money to your ex-spouse as part of a divorce settlement. In both of those cases, your 401(k) money is vulnerable.

Watching Out for Potential Pitfalls

The tax advantages you get with a 401(k) have a flip side: rules. Rules about when you can take your money out, and whether you’ll have to pay a penalty,